Sunday, May 13, 2018

In last week's post I shared some thoughts about Dropbox and why, although Dropbox is unquestionably one of the most amazing SaaS companies ever built, I am a tad less confident in the company's long-term future than I am in other SaaS leaders such as Salesforce.com, Zendesk, or Shopify.

As mentioned in the first part of the post, I took a closer look at Dropbox’s recent IPO filing and would like to share some tidbits, along with a few observations.

#1 – Dropbox on consumerization

"Individual users are changing the way software is adopted and purchasedSoftware purchasing decisions have traditionally been made by an organization’s IT department, which often deploys products that employees don’t like and many refuse to adopt. As individuals increasingly choose their own tools at work, purchasing power has become more decentralized."

As mentioned in the first part, Dropbox was one of the early champions of the "consumerization of enterprise software" movement. This paragraph is a great description of that concept. If you ever have to pitch the idea of consumerization to anyone, copy these lines. :-)

#2 – The King of Freemium

Viral, bottom-up adoptionOur 500 million registered users are our best salespeople. They’ve spread Dropbox to their friends and brought us into their offices. Every year, millions of individual users sign up for Dropbox at work. Bottom-up adoption within organizations has been critical to our success as users increasingly choose their own tools at work. We generate over 90% of our revenue from self-serve channels — users who purchase a subscription through our app or website.

Before reading the S1, I didn’t know if Dropbox has become somewhat more focused on enterprise sales over the years. But here you have it – it really is the King of Freemium, generating more than 90% of revenue from self-service channels.

#3 – It’s a Mouse Hunter!

Dropbox’s ARPU is around $110 per year, confirming that the company is indeed the ultimate Mouse Hunter. It’s worth pointing out that $110 is the average revenue per user, not per account, and one account can consist of multiple users, so the company’s ARPA (which hasn’t been disclosed) is probably significantly higher. However, according to the S1, 70% of the company’s 11 million paying users are on an individual plan as opposed to a "Dropbox Business" team plan, so at least 70% of the company’s revenue does indeed come from mice.

#4 – More than half a million $ per head

As of December 31, 2017, Dropbox had 1,858 employees. Revenue for 2017 was $1.107B. That’s $595,800 per employee. Mind blown. For comparison, according to a Pacific Crest survey among private SaaS companies, the median SaaS revenue per employee of that group of companies was $136,000 in 2016.

Salesforce.com generates a similar (actually, even higher) amount of revenue per employee, but the company is almost twice as old and has much bigger scale, so you’d expect them to be more efficient. When Salesforce had around $1B in revenue, in 2008, it had around 3,300 employees, so at that time its revenue per employee was around $327,000. Not a bad ratio at all, but Dropbox’s revenue-per-employee ratio is truly spectacular – a testament to its extremely effective and efficient bottom-up adoption driven by product virality.

#5 – WTF?!

“Although it is important to our business that our users renew their subscriptions after their existing subscriptions expire and that we expand our commercial relationships with our users, given the volume of our users, we do not track the retention rates of our individual users. As a result, we may be unable to address any retention issues with specific users in a timely manner, which could harm our business.”

We “do not track the retention rate of our individual users”. Wait, what? Did I read this right?

#6 – A unicorn’s worth of office rent

“In October 2017, we entered into a new lease agreement to rent office space in San Francisco, California, to serve as our new corporate headquarters. The total minimum obligations under this lease agreement are expected to be approximately $827.0 million.”

When I read this number for the first time, I was wondering if there’s a typo. $827 million is going to be spent on office rent? A rough calculation shows that the number isn’t as crazy as it might appear on first sight. Assuming the company currently employs around 1,500 people in San Francisco and that that number will grow to 5,000 in the coming years, and assuming it’s a 12 year lease, rent per employee per year (at 5000 employees) would be around $13,800. That’s still expensive, but not “they must have accidentally added a zero” expensive.

#7 – I don’t understand this … is it just me?

“As of December 31, 2017, our blended Annualized Net Revenue Retention across the entire business, including individuals and Dropbox Business customers, was over 90%.”

“We continuously focus on adding new users and increasing the value we offer to them. As a result, each cohort of new users typically generates higher subscription amounts over time. For example, the monthly subscription amount generated by the January 2015 cohort doubled in less than three years after signup. We believe this cohort is representative of a typical cohort in recent periods.”

If you don’t understand how to reconcile these two statements, you’re not alone. Looking at the cohort chart on page 62 of the S1, you’d expect Dropbox to have a significantly negative net dollar churn rate, i.e. net revenue retention of significantly over 100%. The only scenario, in which the two statements above could be compatible, is if a user cohort’s revenue doubles during the first three years but then declines steeply, but I have no idea if that is the case. If you know or have an idea what I’m missing here, I’d love to hear it!

#8 – Weaning off AWS

Look at this. From 2015 to 2017, Dropbox increased revenue from around $600M to ca. $1.1B. During the same period, the company decreased cost of revenue from over $400M to less than $370M. In percentage terms, CoGS decreased from around 67% to around 33%. You don’t often see a company halving its CoGS percentage within two years. Either Dropbox was pretty wasteful in 2015 or they are extremely efficient now. ;-) I think it’s a bit of both.

According to the S1, the remarkable CoGS reduction was achieved primarily by closing accounts of inactive users and by moving more than 90% of all user data from AWS to Dropbox’s own server infrastructure. For what it’s worth, this also gives you a hint on the margins of AWS.

#9 – Eleven 9s?

"Our users trust us with their most important content, and we focus on providing them with a secure and easy-to-use platform. More than 90% of our users’ data is stored on our own custom-built infrastructure, which has been designed from the ground up to be reliable and secure, and to provide annual data durability of at least 99.999999999%. We have datacenter co-location facilities in California, Texas, and Virginia."

I thought six 9s are considered best-in-class, so I was surprised when I counted eleven 9s in this paragraph. Eleven 9s correspond with 0.00032 seconds of downtime per year, which for all practical purposes means that Dropbox can never go down. I re-read the sentence and noticed that Dropbox isn’t referring to availability (i.e. uptime) but data durability, which, as I now know, is something else.

#10 - Multiple personalities?

This is how Dropbox wants to be viewed:

This is how I view it:

If you read the S1 and take a look at Dropbox’s website, it becomes clear that the company wants to become much more than just a service that takes care of file storage and synchronization behind the scenes. They don’t want to be just an icon in your file system, they want to unleash the world’s creative energy by designing a more enlightened way of working (Dropbox’s mission statement).

That makes perfect sense, as being a “background service” might ultimately prove not to be a defensible, high-margin business. I’m somewhat skeptical if their (relatively) new “Paper” product will become a success. But with 500 million registered users, 11 million paying users and 300,000 paying work teams, the company has time to figure it out.

Friday, May 04, 2018

I’m late to the party here, I know. Dropbox went public a bit more than a month ago and I’ve finally had a chance to take a close look at the company’s S1. I’ll be sharing a few specific observations from the S1 review, but let’s start with some more general thoughts about the company.

The mighty king of Freemium

Like Zendesk, Yammer, and a few other SaaS companies that were all founded around 2007-2008, Dropbox was one of the early champions of the "consumerization of the enterprise" movement. In contrast to Zendesk (and I think, Yammer), which eventually moved upmarket and now generates an ever-increasing percentage of revenues from larger customers, Dropbox is still getting most of its revenues from individual users and small teams. The company hasn't disclosed how much revenue it is generating from larger companies, but according to its S1 filing, a staggering 70% of its 11 million paying users are on an individual plan as opposed to a "Dropbox Business" team plans. More than 90% of its users are acquired via self-service channels, presumably driven in large part by the inherent virality of the product. These characteristics make Dropbox the "King of Freemium", as Tomasz put, or the ultimate “Mouse Hunter”.

And what an almighty King it is! Dropbox was the fastest SaaS company ever to hit $1B in ARR. As every aspiring SaaS entrepreneur knows, getting a hundred million dollars in ARR within around eight years is incredibly hard and extremely rare. Getting to more than onebillion within the same timeframe is completely nuts. If the improbability of reaching a $1B valuation is epitomized by a unicorn, getting to $1B in SaaS revenues within eight years is as unlikely as seeing a unicorn with three heads.

Dropbox is one of the very, very few companies in the top left corner of the LTV/CAC chart.

A three-headed unicorn

So what is it that made Dropbox beat all odds? I believe that no single factor alone can explain a success of this magnitude. Instead, I think that the right team has to hit the right opportunity at the right time. Call it the positive equivalent of a perfect storm.
More specifically, here are some factors that I think contributed to Dropbox's success, in no particular order:1. Timing
As consumers tend towards using more devices over time, they’ll experience a bigger need for a solution that synchronizes files across all of their devices. Until 2005 or so, most people used only one or maybe two devices to work with their files: a desktop PC and/or a laptop. Dropbox was founded in 2007, the year the iPhone was launched and just when the move to a multi-device world started to become inevitable. Dropbox also benefited from an ever-increasing number of remote workers who need easy access to their company's files. According to a 2016 study by Deloitte that is mentioned in the S1, 30% of full-time employees primarily work remotely.2. Product
Dropbox managed to beautifully solve a very difficult problem. It might look like a simple product on the surface, but from handling versioning conflicts to building deep integrations with different operating systems to ensuring secure and fast access to files, it required solving a number of hard technology problems. I remember that before switching to Dropbox, I used another piece of software to sync files across two computers. It was pretty messy. With Dropbox it just works.3. Virality
While it's possible to use Dropbox just by yourself, my guess is that at some point, most users use Dropbox to share files with one or more other users. It's this built-in virality that allowed Dropbox to grow at a pace that no other B2B SaaS company has seen before. As if this wasn't enough, Dropbox also had a famous two-sided referral program that augmented the inherent virality with additional referral incentives.4. Team
I don't know the founders of Dropbox, but looking at the quality of the early product and their referral program, it's clear that the founding team combined excellent product and tech skills with a strong growth mindset. In any case, the results speak for themselves – there's no question that a remarkable team must have been at work here.

Dark clouds on the horizon?

As much as I love Dropbox – the product and the company – I'm not entirely sure about the company's long-term prospects. Dropbox's one big weak spot, in my opinion, is that the product is almost UI-less. While you can access your files using Dropbox's (simple) Web app, there's very little need for it. We use Dropbox for all of our files at Point Nine and I have it running on four devices, but Dropbox does its magic almost entirely in the background. That makes me think that Dropbox is much less sticky than other SaaS products, e.g. workflow tools that require training. I could imagine that if a company's IT department decides to switch the file storage and sharing provider for its entire workforce overnight, most people wouldn't even notice it. In contrast, imagine the outcry that would ensue if you took away Zendesk from a support team or if you tried to get your development team off Slack.

Would I switch to another provider to save $20 a year? No, not worth the hassle. Would I consider moving all files to Google Drive if it's significantly cheaper and if a tighter integration with GMail, Google Calendar and Google Docs offers more and more benefits? Yes. (Interestingly Google Drive’s “Quick Access” feature is already using e.g. information from your calendar to predict which file you are likely to need at which point in time.)

I think the company has recognized this issue. Two and a half years ago they launched "Paper", a collaborative document-editing app, presumably to get more "face time" with its customers and to own a bigger part of the value creation chain. However, I know almost nobody who uses Paper and the company doesn't disclose any usage numbers, so my guess is that it's not a big success so far.

Don't get me wrong, more than $1B in ARR and 500 million registered users are an incredible asset. The King of Freemium won't be dethroned any time soon. But for what it’s worth I didn't buy the stock yet :-)